Download Capital requirements for MiFID investment firms

Capital requirements for MiFID investment firms – all change?
1
June 2016
Briefing note
Capital requirements for MiFID
investment firms – all change?
In a December 2015 report the European Banking Authority (EBA) recommends
significant changes to the EU's regulatory capital rules for MiFID investment
firms. The proposed changes are relevant to asset managers and a wide range
of other non-bank investment firms. The report criticises the current legal
framework as overly complex and recommends replacing it with a simpler, more
proportionate system that better reflects the different risk profile of investment
firms compared to banks. The report's main focus is on the framework for
establishing prudential requirements for investment firms rather than the
eligibility of different instruments to satisfy those requirements.
The status quo
Under the CRR / CRD IV, MiFID
investment firms are subject to the
same basic regulatory capital
framework (derived from Basel
standards) that applies to EU banks.
This framework already takes some
account of the differences between
banks and investment firms. The CRR
/ CRD IV establishes tailored
prudential regimes for different
categories of investment firm. These
categories use the various MiFID
investment services that investment
firms conduct as proxies for the risks
that firms pose to investors and to the
system as a whole. Whether or not an
investment firm is authorised to hold
client money is a particularly
important factor. All categories are
subject to some level of initial capital
requirement, and most categories are
subject to some level of own funds
requirements, as outlined in Table 1.
Existing attempts under the CRR /
CRD IV framework to tailor prudential
rules for non-banks have produced a
confusing array of at least eleven
different EU regulatory capital
regimes for investment firms.
Divergent national implementation of
relevant Directives means that in
reality the situation is even more
complex. For example, the definition
of MiFID investment services and
activities varies across Member
States and there is no harmonized EU
wide definition of what it means to
hold client money and securities.
These differences can produce
anomalous outcomes where firms in
different Member States may be
subject to different rules despite
conducting fundamentally similar
activities.
However, divergent national
implementation may be of less
practical significance when
considering how EU prudential rules
for investment firms disproportionately
impact a few Member States. The
report observes that of the 6,500
MiFID investment firms in the EU (not
counting AIFMs and UCITS
management companies that conduct
MiFID services and activities) just
over half are based in the UK while
France, Germany and the UK
together account for more than 70%
of all EU investment firms.
The report concludes that the scope
of a firm's MiFID permissions is not
necessarily a good proxy for risk.
Under current rules a firm whose sole
MiFID activity is to place financial
instruments without a firm
commitment is hit by the highest initial
capital requirement (of EUR 730,000).
By contrast, a firm using its
permission to receive and transmit
orders to conduct fundamentally
similar activity in the secondary
markets can avail of a lower initial
capital requirement of EUR 125,000.
The treatment of portfolio managers
under the current regime is also
unusual in that all managers are
subject to the same regime, with no
account taken of portfolio size. The
report also observes that a firm with a
proprietary trading permission and no
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Capital requirements for MiFID investment firms – all change?
external clients is currently hit by the
full CRD IV regime. This may make
sense if the firm is part of a banking
group but seems harder to justify for a
standalone firm with limited
connections and low systemic
significance.
Table 1: current categorisation of MiFID investment firms within the CRD framework
Categories
Initial capital
Own funds
requirements
€50 000 (CRD 30)
Not applicable
1
Local firms (CRR 4(1)(4))
2
Firms falling under CRR 4(1)(2)(c) that only provide
reception/transmission and/or investment advice
€50 000 (CRD 31(1))
Not applicable
3
Firms falling under CRR 4(1)(2)(c) that only provide
reception/transmission and/or investment advice and are
registered under the Insurance Mediation Directive (IMD)
€25 000 (CRD 31(2))
Not applicable
4
Firms falling under CRR 4(1)(2)(c) that perform, at least,
execution of orders and/or portfolio management
€50 000 (CRD 31(1))
CRR 95(2)
5
Investment firms not authorised to perform deals on own
account and/or underwriting/placing with firm commitment that
do not hold client funds/securities
€50 000 (CRD (29(3))
CRR 95(1)
6
Investment firms not authorised to perform deals on own
account and/or underwriting/placing with firm commitment but
hold client funds/securities
€125 000 (CRD 29(1))
CRR 95(1)
7
Investment firms that operate an MTF
€730 000 (CRD 28(2))
CRR 95(1)
8
Investment firms that only perform deals on own account to
execute client orders
€730 000 (CRD 28(2))
CRR 96(1)(a)
9
Investment firms that do not hold client funds/securities, only
perform deals on own account, and have no external clients
€730 000 (CRD 28(2))
CRR 96(1)(b)
10
Commodity derivatives investment firms that are not exempt
under the MiFID
€50 000 to 730 000
(CRD 28 or 29)
CRR 493 & 498
11
Investment firms that do not fall under the other categories
€730 000
CRR 92
(CRD 28(2))
Source: EBA December 2015 Report on investment firms, EBA/Op/2015/20
The EBA proposals
The EBA report concludes that the
existing set up is far too complicated.
In place of the current, eleven
categories, the EBA outlines a three
tier approach that focuses on the
relative systemic significance of firms
and the extent to which they take
'bank-like' risks.
1.
First, the full set of CRR / CRD IV
rules would apply to the most
systemically important firms
(systemic firms) conducting
large scale intermediation and
underwriting activities and facing
significant counterparty credit risk,
as well as market risk on assets
held on their own account
(whether or not for external
clients).
2.
Secondly, a simpler regime
would apply to less systemically
significant firms (non-systemic
firms), with a focus on the
specific risks these firms pose to
investors or other market
participants through credit,
market, liquidity and operational
risks.
Capital requirements for MiFID investment firms – all change?
3.
Finally, the simplest regime
would apply to small, noninterconnected firms. This regime
could be based on fixed
overheads and large exposure
rules with the aim of setting aside
enough capital for an orderly
wind down. Simpler reporting
rules could also apply to this
category.
Measuring the systemic importance of
a firm and setting the boundaries
between these three categories would
involve qualitative and quantitative
assessments. The EBA outline some
pros and cons of different
measurement approaches. Having
fixed, nominal thresholds common to
all Member States would be clear and
simple but could mean that some
firms (while systemically significant
domestically in their home states) are
never caught in the highest category.
An alternative approach would be to
set quantitative thresholds in
percentage rather than nominal terms
(e.g. a firm crosses a threshold if its
balance sheet comprises more than a
certain percentage of the total
balance sheet of all firms). Such an
approach would have the advantage
of not distinguishing between Member
States on size grounds. However, in
some Member States it could push
some nominally smaller firms into a
higher category. A third approach
outlined in the report would give
Member States more flexibility to take
into account local factors.
Which firms would benefit and which
would suffer additional capital costs
from a simpler regime would depend
to a large extent on the method
chosen to set the boundaries between
the three tiers proposed. In the UK at
least, it seems probable that a simpler
regime would make most difference to
smaller firms subject to FCA
prudential supervision. For large UK
investment firms subject to PRA
prudential supervision, the changes
outlined in the EBA report may not
make a great deal of difference and
might, in certain cases, pose an
increased regulatory capital burden.
In terms of assets under management,
the report observes a skewed
distribution of firms, with a mere eight
firms representing around 80% of all
EU investment firm assets. However,
in gauging systemic significance the
EBA warns against placing too much
emphasis on balance sheet size
noting that balance sheet data
provides no information on intraday
exposures, concentration risk or
idiosyncrasies of business models.
The report emphasises the
importance of gauging operational
risk when setting prudential
requirements for MiFID investment
firms. The report questions whether
expenditure based metrics like fixed
overhead requirements (FOR) are the
best tool for this job. Current fixed
overhead requirements in the CRR
also apply to AIFMs and UCITS
3
management companies whose own
funds requirements under AIFMD and
the UCITS Directives can never be
less than their fixed overhead
requirement calculated under the
CRR (25% per cent of the previous
year's fixed overheads). The report
identifies both pros and cons of FOR
and indicates that if changes to FOR
are made for MiFID investment firms,
the impact on AIFMs and UCITS
management companies needs to be
considered as well.
The report also considers the
prudential regulation of commodities
dealers and recommends extending
the exemption that they currently
enjoy from CRR capital requirements
from December 2017 until December
2020. On 11 May 2016 the European
Parliament adopted a proposed
Regulation to give effect this
extension. That legislative proposal
will now be considered by the Council.
What next?
The Investment Association has
welcomed the report's
recommendations as an important
first step in overhauling EU prudential
rules for investment firms. It is unlikely
that we will see any formal legislative
proposal before 2018. In the
meantime, the EBA will conduct
further work on the possible
quantitative and qualitative
underpinnings of any new regime.
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Capital requirements for MiFID investment firms – all change?
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Caroline Meinertz
Partner
Monica Sah
Partner
Sean Kerr
Senior Associate PSL
T: +44 207006 4253
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@cliffordchance.com
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E: monica.sah
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@cliffordchance.com
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